Chapter 8: Margin Power
Contents
As long as money has existed, risk-takers have multiplied their efforts through the use of other people’s money. There is probably no place where the use of other people’s money can be used to such advantage (if you have a well-thought out plan) or to court disaster (if you don’t have a plan) than the stock market. In real estate, for instance, you can borrow money, but there will be a banker there to make sure you don’t make too bad a deal and thus put the bank’s loan in jeopardy. In the stock market there are few such safeguards. You are free to lose all of your money (and more) if you are not judicious in the use of debt leverage.
In the stock market, it is possible to easily borrow money, using the value of the stocks you own as collateral. As of this writing, current margin rules allow a person to borrow in order to buy up to twice as much stock as you have cash in your account. By using margin, you now magically have the same number of dollars in your account, but more stock than you had before. This practice is called trading on margin. Does it sound risky? You had better believe that it is, if it’s done in an uncontrolled fashion. When using margin, the need to have an airtight plan and the discipline to follow that plan is doubly important. Even then, people can and do lose money trading on margin, because you can never tell what will happen in the stock market. However, if you do have a reasonable plan and discipline, you can obviously make a lot more money in stocks than you can by trading from a 100% cash position. If you try trading on margin, you can lose a lot more money than you could on a cash-only basis. So, be aware of the risks of margin as well as the potential.
The Reverse Scale Strategy that we just introduced can be used with margin leverage while keeping the risk to a manageable level. To effectively use margin, the first, most important rule is that you never borrow money in order to add more shares to a losing position. If you are carrying a losing position on anything, it is by definition trending downward at least from your entry point. As you have seen, in the Reverse Scale Strategy we only add to positions as they are trending in our favor, upward. We already concluded that we didn’t want to buy into downtrending stocks even when trading from a cash position. We certainly don’t want to add to any losing position, and with the ability of margin to magnify gains and losses we must be especially careful not to add to a losing position when we are borrowing to do it.
The other thing to keep in mind with the use of margin is that while current regulations allow us to finance up to 50% of the value of the stocks we own, such a level of leverage is almost never a wise move. For instance, if you have a $20,000 account you can borrow from your broker to purchase up to $40,000 worth of stock. The use of that much leverage means you are paying a huge amount of interest relative to the cash in your account, which will deplete your capital rapidly with each passing day if your stocks happen to sit idle and mark time. This use of the maximum allowable amount of margin leverage also means that if the position moves against you, you are likely to lose a huge amount of your account equity, in other words the part of the account you actually own. In fact, with margin you can actually end up losing more than all of your money, under the most extreme conditions.
As we said before, current regulations allow us to buy twice as much stock as we have cash. That is the most risk we are allowed to take, but we are not going to take anywhere near that level of risk with our hard-earned money. So, our rule for use of margin will be:
To control our use of leverage, We will choose our initial position size in a stock so that we will always have enough cash on hand to make our inital purchase and half of our second purchase, without borrowing anything.
In the chart below, I’ve taken our previous chart for illustrating the Reverse Scale Strategy and added two columns, “Percent financed,” and “Cumulative Cash Deposited.” Since each successive purchase is always $1,000 in value in this example, we deposit $1,000 to make the first purchase and $500 to make the second purchase in accordance with our rule for margin trading. Our total cash deposited for this trade is therefore $1,500.
Reverse Scale Strategy, 50% Price Increments (Chart #1).
| Decision Point Price Level |
Amount Invested this Purchase * |
Shares Bought this Purchase | Cumulative $ Invested | Cumulative Shares Owned | Current Value of Shares | Total $ Profit/(Loss) | Total $ Borrowed | Percent of Position Financed | Cumulative Cash Deposited |
|---|---|---|---|---|---|---|---|---|---|
|
20 |
$1,000 |
50 |
$1,000 |
50 |
$1,000 |
$0 |
$0 |
0.0% |
$1,000 |
|
30 |
$990 |
33 |
$1,990 |
83 |
$2,490 |
$500 |
$490 |
19.7% |
$1,500 |
|
45 |
$990 |
22 |
$2,980 |
105 |
$4,725 |
$1,745 |
$1,480 |
31.3% |
$1,500 |
|
67 4/8 |
$1,013 |
15 |
$3,993 |
120 |
$8,100 |
$4,108 |
$2,493 |
30.8% |
$1,500 |
|
101 2/8 |
$1,013 |
10 |
$5,005 |
130 |
$13,163 |
$8,158 |
$3,505 |
26.6% |
$1,500 |
|
151 7/8 |
$1,063 |
7 |
$6,068 |
137 |
$20,807 |
$14,739 |
$4,568 |
22.0% |
$1,500 |
|
227 7/8 |
$911 |
4 |
$6,979 |
141 |
$32,122 |
$25,142 |
$5,479 |
17.1% |
$1,500 |
* Since shares can only be bought in increments of one, this number does not always equal $1,000 for each purchase, but the cost of the closest increment of one share that can be purchased with $1,000.
The Cumulative Cash Deposited column shows the total amount of our own dollars we would have deposited, which in this example is never more than $1,500. This column added to the Cumulative Dollars Invested column and the Total Profit/(loss) column equals the Current Value of Shares column, because the current value of the stock we’ve invested in is composed of three elements: 1)The cash we’ve deposited (think of it as our down payment, 2) The amount we’ve borrowed from the broker (think of this as our mortgage on the stock), and 3) The accumulated profit we carry in the position. You see, the broker’s regulation requires us to only put up 50% of the value of the stock, and we can use any unrealized gain as part of the 50% downpayment we are required to make. This means that once we get to the third purchase and beyond, neither the broker’s regulations nor our trading rule requires us to add any more of our own money to the trade, no matter how many more purchases our strategy requires us to make.
The Percent Financed column shows how much of the current value of stock we own is financed with borrowings from our broker. As you can see, at no time do we even get close to the 50% threshhold, since the maximum borrowing we do tops out at 31.3% of security value as we add our third position. From then on, our profits snowball to such an extent that we are not required to add another dime of our own money to the trade for each purchase after the second one, no matter how many purchases we eventually end up making. Yet, our percent financed declines for each position added after the third one. The beauty of this approach is that when we lock onto a real winner, can really pile onto the position without putting up much of our own money. From the chart, you can see that should we execute our strategy on a stock which runs from $20/share to $227 7/8, we will have an open profit of $25,142, less the minimal amount of interest paid on the borrowed portion and commissions. Our total investment of our own cash was only $1,500 on the trade. You may not find a stock like this every year, but they are inevitable if you stick with the Reverse Scale Strategy and the stock picking criteria from Chapter 4. If you look at the Total Profit column, you will see that you do not need anything even close to a tenfold move to make a large profit relative to the $1,500 of your own money invested.
The decision to use margin or not is yours alone. You can still use the Reverse Scale Strategy without borrowing, by simply ceasing to buy additional positions when you run out of cash. The decision points in the chart are still useful in such a case for deciding when to sell out your position. Obviously, the use of margin makes a big difference in your return only when the stock makes a big move. Here is how the profit picture would look if you simply took a $1,000 position and didn’t add to it at all:
Reverse Scale Strategy, no margin leverage (Chart #2):
| Decision Point Price Level |
Amount Invested this Purchase * |
Shares Bought this Purchase | Cumulative $ Invested | Cumulative Shares Owned | Current Value of Shares | Total $ Profit/(Loss) | Total $ Borrowed | Percent of Position Financed | Cumulative Cash Deposited |
|---|---|---|---|---|---|---|---|---|---|
| 20 | $1,000 | 50 | $1,000 | 50 | $1,000 | $0 | $0 | 0.0% | $1,000 |
| 30 | $0 | 0 | $1,000 | 50 | $1,500 | $500 | $0 | 0.0% | $1,000 |
| 45 | $0 | 0 | $1,000 | 50 | $2,250 | $1,250 | $0 | 0.0% | $1,000 |
| 67 4/8 | $0 | 0 | $1,000 | 50 | $3,375 | $2,375 | $0 | 0.0% | $1,000 |
| 101 2/8 | $0 | 0 | $1,000 | 50 | $5,063 | $4,063 | $0 | 0.0% | $1,000 |
| 151 7/8 | $0 | 0 | $1,000 | 50 | $7,594 | $6,594 | $0 | 0.0% | $1,000 |
| 227 7/8 | $0 | 0 | $1,000 | 50 | $11,391 | $10,391 | $0 | 0.0% | $1,000 |
Using both Chart #1 and Chart #2, we can construct the following comparison of the profit results of the same trade both with and without using margin leverage:
Profit Comparison of Margin versus Cash-only Basis (Chart #3):
| Price Level | Profit Using Margin |
Profit Without Margin |
Additional Profit from Margin |
|---|---|---|---|
| 20 | $0 | $0 | $0 |
| 30 | $500 | $500 | $0 |
| 45 | $1,745 | $1,250 | $495 |
| 67 4/8 | $4,108 | $2,375 | $1,733 |
| 101 2/8 | $8,158 | $4,063 | $4,095 |
| 151 7/8 | $14,739 | $6,594 | $8,145 |
| 227 7/8 | $25,142 | $10,391 | $14,751 |
So, if the stock moves from $20 to $227 7/8, the difference in profit is nearly $15,000, whereas the difference in our own dollars invested is only $500 (the $1,500 deposit in the margin example versus the $1,000 cash deposit in the non-margined example). For stock trends of smaller proportions, the differences are less huge, but still substantial.
The use of margin is always more risky than not using it. This is simply because whatever you do to try to control the risk, you still own more shares than you would if you were trading without the use of borrowed money. However, I feel anyone who is comfortable taking a little more risk for a lot more potential reward should use margin, and I will assume throughout this book that the reader intends to use margin in building stock positions using the Reverse Scale Strategy.
Precautionary Guidelines
Some important principles to remember when using the Reverse Scale Strategy:
- Never buy a larger dollar position in your subsequent positions than you took in the initial entry into the trade. In our example where we bought $1,000 of stock at 20, for instance, never buy more than $1,000 of that stock in any single subsequent purchase. If you break this rule you will increase your average cost per share significantly enough that you will practically guarantee yourself a loss at some point.
- Only buy at the decision points. Don’t try to make “extra” buys between decision points. This is just another way of breaking the first rule and leaves you exposed.
- Never set your decision points closer than 50% in price above the previous one. If you do, you can get whipsawed by normal market fluctuations, resulting in less profit and exiting trends prematurely. You will kick yourself as you watch your stock recover and start making new highs once again – without you.
- Do not depart from these guidelines!
Applying the Reverse Scale Strategy to Portfolios of Stocks
Up until now we have concentrated on how you would go about making buy and sell decisions for just one stock at a time, because it’s much easier to explain the concepts this way. It’s easy to adapt the Reverse Scale Strategy to a portfolio environment because all we have to do is construct a separate decision chart for each of the five, ten, or however many stocks are in our portfolio, and begin with an equal dollar amount in each stock. In the next chapter we will review in a step-by-step manner how to use our strategy to accumulate and manage a portfolio of stocks.
When using the Reverse Scale Strategy to manage a portfolio of stocks, always begin with an equal dollar amount invested in each stock. Do not try to guess which stocks will perform best.
Diversification
For the sake of being clearly understood, let me state this in no uncertain terms: You should never invest a major amount of money in just one stock. For one thing, it is risky because all of your eggs are in one basket. Furthermore, it is unnecessarily risky. If you have a number of stocks in your portfolio and use the Reverse Scale Strategy, those few that perform exceptionally well will be added to as they progress upward in price. This will guarantee that in the final analysis your best-performing stocks will make up a larger percentage of your portfolio than your poorer-performing ones. So you don’t need to try to second-guess which stock will perform best beforehand.
If you are disciplined and follow the strategy, you will have the benefit of starting with a shotgun approach at the outset and progressing to more of a rifle-shot as the winners begin to emerge. So don’t try to hit a home run by investing all your money in one stock. Chances are, you’ll simply strike out.Ignoring principles of diversification and investing your money in only one stock is a risky and foolhardy thing to do – don’t do it.
In my opinion, you should never invest in less than five stocks to begin with, and that’s the bare minimum number assuming you just don’t have enough money to invest in more. As a rule of thumb, aim to have about ten stocks in a Reverse Scale Strategy portfolio. There is nothing magical about the number ten, but I feel this number represents a good balance between diversification and the time required for tracking the stocks.
Do not churn your account!
Once you have chosen the stocks you will trade, do not change stocks (selling one, buying another) unless it meets the predetermined exit plan. That is, do not sell a stock unless it hits one decision point below the previously achieved decision point. Ever. If you do depart from this system you will no doubt end up making emotional decisions, and they will most likely be poor ones. Plus, you will lose peace of mind because you will no longer have a plan that you are resolved to stick with no matter what. In short, you’ll be right back where you were before you read this book.
There have been a number of studies over the years showing that excessive trading tends to reduce investment results. The other name for excessive trading is churning. Whatever you call it, it is a waste of time and generally is a tipoff that the investor doing this is confused about their strategy or is investing for excitement rather than profits.
If you resolve to use the Reverse Scale Strategy, stick with it consistently. In the long run it will be the best policy.
Guidelines for placing orders
Market orders versus Limit Orders
When you place an order with your broker, they will ask you if you want to execute your trade as a market order or as a limit order. You should always use market orders when buying or selling stocks. A market order specifies a willingness to buy at the current market price, whatever it may be. A limit order instructs the broker to buy at a specified price. A market order ensures that you will have your order filled, but the exact price is not guaranteed. A limit order guarantees that you will not pay a higher price than you specified, but does not guarantee that your order will be filled.
So why not use limit orders? Because if you do, you will find that what would have been your most profitable orders are seldom filled, as the market moves away from your specified price. On the other hand, the orders that are filled on a limit order will most likely turn out to not be your best potential trades. The reason for this is that stocks of companies where something really good is happening will move steadily upward at times, without pausing to backtrack and fill the orders of those who have decided to use limit orders. The use of limit orders generally means that a person is being greedy, hoping to cut his purchase price by a small amount. But, instead, the hapless limit-orderer is constantly left behind by the really good stocks, and wonders why his biggest fish got away.
Bottom line, in real life with the Reverse Scale Strategy it is not critical that you get filled at exactly the prices listed in the decision chart. We are going after the big gains and a quarter or half-point variation won’t matter much in the long run. It is important to always use market orders as opposed to limit orders. It is much more important to get your order executed than it is to get a specific price.
Stop-loss orders
There is another type of order you should know about, called a stop-loss order. They are commonly referred to as simply 壮top orders.’ This order is placed below the market price if it is a sell stop order, or above the market if it is a buy stop. If the stock’s market price reaches the price specified in the stop order, then the stop order becomes a market order to buy or sell. As an example, let’s say we bought shares of ABC Co. at $20. They then rise to reach the first decision point price of $30/share, signaling that our sell signal will be reached if and when the price of the stock goes to $20. We could place a sell stop order for our shares at $20, which would instruct the broker to enter a market order to sell our shares if and only if the market price of ABC Co. again returns to $20 or below. If we enter it on a good till cancelled basis, (GTC), the order will stand until it is either triggered by the stock’s price reaching $20, or until we cancel the order. If you do not specify GTC status for this or any other type of order, your order will be classified as a day order, meaning it will expire at the end of the day it is entered. So be careful to specify GTC on stop orders if you want them to last more than a day. Otherwise you may have a false sense of security that your order is still entered when it really is not.
Currently, stop orders are only available on listed (New York Stock Exchange and American Stock Exchange) stocks, and not on NASDAQ (Over-the Counter) stocks. However, some brokers are starting to offer stop orders on NASDAQ stocks. So, perhaps soon these orders may be available for all stocks in your portfolio. I certainly hope so, because stop orders are a very useful thing for the average investor who cannot be watching the market constantly. They in essence watch it for you.
If you cannot watch the market during the day (and who can?), I encourage the use of stop orders once you have accumulated a large position in a company’s stock. The decision point parameters are set far enough apart with the Reverse Scale Strategy that using intraday prices (which is what stop orders are triggered by) or closing prices will not likely change your performance very much and may give you greater peace of mind.
Five Minute Investing Course
Introduction
Chapter 1: Replacing Our Stock Market Myths
Chapter 2: Things to Avoid
Chapter 3: Know Yourself
Chapter 4: Stock Picking
Chapter 5: How to Evaluate a Trading Strategy
Chapter 6: The World’s Worst Trading Strategy
Chapter 7: The Reverse Scale Strategy
Chapter 8: Margin Power
Chapter 9: Implementing the Reverse Scale Strategy
Chapter 10: Getting Started